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Sunday, 1 November 2009

Too Big to Fail

Too Big to Fail

1st November 2009

The Malta Independent on Sunday

Alfred Mifsud

Now that the
international financial crisis appears to have stabilised after massive
interventions by governments, monetary authorities and regulators, focus is
shifting from mere survival to re-designing the financial system to ensure that
what happened will never happen again.

In this context the whole argument
revolves on how to tackle the “too big to fail” moral hazard risk.

If
failure of one of the smaller financial institutions like Lehman Brothers proved
big enough for the whole financial system to seize up, then the new regulatory
regime has to be designed to ensure that no single institution, no matter how
big, should pose such a grave systemic risk.

The present system of moral
hazard is untenable. It is scandalous that significantly important financial
institutions are allowed to pass on to their shareholders and their bonus rich
employees the benefit of the profitable years in the knowledge that if they hit
a rock the taxpayers will bail them out, as they are too important to be allowed
to fail without bringing down the whole financial system.

There is
therefore broad agreement that in the new regulatory regime no financial
institution will be allowed to be, or become, too big to fail. After all,
failure lies at the core of market based systems and we cannot safely have a
properly functioning privately owned market based financial system if the
possibility of failure is excluded and the taxpayer can be relied on to
underwrite losses to save the system from imploding, as happened in
2008/2009

Where there exists a substantial difference of opinion is over
how the “too big to fail” institutions can be forced to downsize and thus stop
being a systemic risk if allowed to fail.

There is one school of
thought, championed by the governor of the Bank of England Mervyn King, which
argues that the problem has to be addressed in a direct manner. Institutions
categorised as being systemically important simply have to be forced to get
smaller by separating their traditional deposit taking and financial
intermediation role from their investment banking operations.

This would
largely be a return to the Glass Steagall Act of 1933 introduced in the US
following the Great Depression, which effectively prohibited commercial banking
(deposit taking and commercial lending that was considered as a utility
provision critically important for economic growth through the supply of credit
and therefore prohibited from undertaking risky speculative dealing in market
instruments for their own treasuries) from teaming up with investment banking,
which effectively gets involved not only in executing third party deals but
operate their own large treasuries taking risky positions in trades for their
own account. Mervyn King has reiterated that casino operations have no place to
co-exist within banking organisations providing credit utility
services.

Another school of thought considers such an approach
impractical, as it is unlikely to find international application and would
merely involve regulatory arbitrage with large banking organisations merely
shifting to a softer regulatory regime. In such a case, London, which is where
Mervyn King has his throne, being the largest international financial centre,
would be a net loser. This explains why King is not exactly the darling of the
British Chancellor of the Exchequer Alistair Darling.

The school of
Alistair Darling argues that it would be difficult and indeed unreasonable to
force such a direct division. To be effective, such a division would have to
mandate that investment banks be wholly financed outside the commercial banking
system so as not to retain any indirect exposure by the latter to the former,
and this is quite impossible. Furthermore, it is quite imaginable that if such
strict separation were enforced, commercial banking per se would gradually
wither away as depositors would switch their deposit funding on low rates to
higher income funding on the markets offered by the investment banks. This would
effectively downgrade the critical financial intermediation role of the
commercial banking system.

The Darling school of thought wants to address
the “too big to fail” anomaly by introducing more rigorous capital requirements
for banks, which apart from conducting pure commercial banking operations also
operate investment banking operations, as all large international banks
currently do. So their argument goes that the bigger the bank, and the bigger
the risks undertaken by such big banks, the bigger the capital requirements
demanded. Effectively, this would act as a market-based disincentive to keep
large investment banking operations within the same structure of commercial
banking. In time, banks would realise that it would be more profitable to
conduct such investment banking operations in hedge fund types of structures,
which are entirely funded by investors capital, with strict limits on leverage,
and which can pay as much bonuses as they want to their star performers, as
their operation would not involve the taxpayer in any expense or subsidy, or
even in implicit guarantees.

Building on this concept, the US House of
Representatives banking committee is proposing that any future bail out funded
by taxpayers would have to be funded directly by taxing the surviving banks.
There is an argument whether such funding should come a priori by building
reserves in good times, as is done with the operation of the deposit insurance
schemes, or should be triggered by events a posteriori. Many argue that the
latter would be quite difficult, as the triggering event would render surviving
banking institutions too weak to carry the burden of additional
taxation.

This financial crisis has produced new catchwords and phrases
that will remain embedded in the language. We have now passed from “toxic
assets” to “too big to fail”.

It is inevitable that the banking sector
has to pay the price of much heavier regulation once it has proved itself
untrustworthy to operate in a light touch regulatory environment that relies on
self-regulation. Banks have involved the taxpayer in heavy losses and shamed
their regulators and monetary authorities who had defended their freedom as
leading to better risk distribution and financial efficiency. Events have proved
that the reality was totally different.

Banks that survived are not
helping their own case by resorting so quickly to scandalous employee bonuses
distribution without taking into consideration that their own survival is due to
explicit or implicit taxpayer guarantees, and that the huge profits they are
registering after the huge losses of the crisis are only due to the
exceptionally low interest environment that monetary authorities had to engineer
to facilitate the recovery. Such short-term reasoning by greedy bankers will
only mean more and stricter regulation for the longer term.

How to
resolve the “too big to fail” hazard remains under discussion. But it has to be
resolved as otherwise, after solving and emerging from this financial crisis, we
are only sowing the moral hazard seeds for the next one, which will be bigger
and more devastating. The taxpayer is unlikely to be willing or able to help out
again.